Whenever you spend money on your business, the expense is either deducted on your federal tax return in the year it is incurred or depreciated over time. But much more is involved than just that. And when you hear terms like capitalization and safe harbor, it can feel even more complicated. Here are details to help you better understand the process.
- Deductible costs: These are the day-to-day costs of operating your business, such as rent, insurance, maintenance, and office supplies. The Internal Revenue Service lets you deduct all these “ordinary and necessary expenses” during the taxable year in which they are incurred.
- Capital costs: These are payments you make to acquire or improve your building and equipment. These costs, such as upgrading an HVAC system, are considered to be business investments that add to the value of your asset. Capital costs are depreciated on tax returns over the course of their “useful life” as determined by the IRS. The useful life of a laptop, for instance, is three years, whereas the useful life of telecommunications equipment is seven years. Sometimes, intangible assets, such as patents and trademarks, are considered capital expenses.
It seems straightforward. But, in fact, determining whether a cost must be capitalized over X years isn’t as easy as it looks. And, to make accounting even more fun, the IRS has a “de minimis safe harbor election” that lets you deduct expenses that you otherwise would capitalize.
De Minimis Safe Harbor
The de minimis (Latin for “concerning the smallest things”) safe harbor is a yearly tax return election that allows you to deduct expenses for tangible property that costs below a certain threshold. Essentially, it gives taxpayers an immediate but limited tax break on items that otherwise would take many years to depreciate.
The IRS increased the threshold from $500 to $2,500 for businesses that don’t have an audited financial statement, something many small businesses do not have. This means that if your small business bought, for example, a computer for $2,499, you might be able to deduct the entire amount on that year’s tax return, instead of over many years. For businesses that maintain an audited financial statement, the threshold continues to be $5,000.
De minimis safe harbor makes recordkeeping easier because asset capitalization and depreciation does not need to be tracked. However, there are certain times when the safe harbor is not the best tax planning strategy. If a business is growing rapidly, future years would be expected to generate larger taxable income amounts. In that case, deferring tax deductions could offset a larger tax liability due to the graduated tax rate. If the marginal tax rate is expected to increase in future years, it may be beneficial to capitalize those small expenditures. Consult with a tax professional to determine if it would be beneficial for you to elect the safe harbor.
